Any good book on Statistical Arbitrage?

For those who are trading with stat arb strategies, can any of you recommend some books to learn about this topic? Also, what is the typical trade duration for such strategies? What kind of software setup is required? Can this kind of strategies be implemented with a retail broker like IB or does it require much more sophisticated platform?

I know some of you will think I am asking for trade secrets. I am not. I am just sincerely curious about this type of strategies since they are mentioned a lot but not many people talk about details. I would like to learn about what the general premise is, what markets are stat arb usually employed, and what kind of specific mathematical analysis is involved.

Thanks in advance for any clarification.

 

Hi

I have taken a fair bit from Elite over the years (just running keyword searches over the old posts throws up heaps of good stuff) so here I am giving something back. I do stat arb every day and make money so I know a thing or two about it.

Many people will most likely recommend: Pairs trading By Ganapathy Vidyamurthy. Its OK, however I found a more recent book titled Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernie Chan a more practical read. He has a blog that goes into many stat arb issues.

In addition I know guys getting reasonable results from spearman correlations. You can get a good Excel spreadsheet and explanation by hunting around http://www.gummy-stuff.org/. He has a Google search add in at the site - look for “spearman”. Also try “pairs trading”.

I use IB and my best results are from stat arb between an ETF and say ten of its constituent stocks (hint: select the stocks by regressing against the ETF)

With the basket method you have you outlay a lot more $$ as you are buying around 11 stocks/ETFs so that can be around $60K in a hit (based on 100 share minimums).

I'm mainly using MATLAB and IB, some Excel and IB, but am following up on the openquant idea posted by dareminator on 04-29-08.

I’ve been profitable using derivations of the above from the get go – mainly intra-day and basket construction methods. These mean reversion (MV) strategies have a lot going for them. However, you do need to play around with the models a bit, particularly if you want to try and get arb going across different industry sectors (what links them – if anything – maybe try a factor model…..) or build your own indices to trade against a basket. It’s no coincidence that the big boys play in the stat arb space because it is an area in which an edge can be found.

A lot of people throw pairs trading in after a couple of single pairs trades go bad, that’s why you need to look at baskets and ETFs – they provide a form of diversification. However, you need more cash to play using that strategy hence a few less players and therefore a bit less info on the ground about how to go about it. The Hedge funds are all over it but on a much larger scale.

With stat arb you can go into smaller timeframes including intra-day – I’m sure I once downloaded a recording of Don Bright and Maverick(??) discussing prop trading and Don said they encouraged intra-day pair strategies – I may be wrong – but anyway I have had good success in that space as well.

Throw in options and futures and you have a whole lot more strategies. A lot of people will talk about Aug 2007 and the quant strategy crashes, but you can do hedging with ETF options. Try running cointegrations over spread trades. There are heaps of ideas and plays to look at.

I’ve written a bit and in a way I’m responding to all those people what write “it takes years to be profitable, or what’s a good system, or what indicator to use etc”. Stat arb is where it’s at (for me at least). As for the maths – understand correlation, regression, mean reversion, standard deviation – you can learn it all on the web – you only need a working knowledge - and that gummy reference is a good place to start. He’s going to take that site down soon so have a look now if you are interested. He has heaps of models and spreadsheets that he encourages people to use. I’ve had no difficulty adding the IB TWS API into his stuff.

Once you are in the stat arb space directional plays also can be derived – obviously you’re not hedged so to speak but the logic of MV throws up lots of ideas.

So in summary these should get you going:
http://epchan.blogspot.com/
http://www.gummy-stuff.org
Pairs trading By Ganapathy Vidyamurthy
Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernie Chan

 

Hi Matt,

WOW. I was not expecting such a long and serious answer to this apparent newbie question. Your comment is highly appreciated.

I have actually just finished E. P. Chan's book a couple months ago and found it a very excellent book for dealing with practical issues in automated quant trading. It only touches on stat arb a little bit as a side though.

Your experience is very enlightening. From what you described about your own trading, it seems like stat arb can be implemented with tools that are accessible to retail traders and doesn't have to be ultra-high-frequency.

I will check out the pair trading book and that website you mentioned. Thanks again for the very very helpful response.

 

Good post.

So how was Aug. 2007 for you?

 

Hi Matt,

Can you describe, in very general terms, the performance statistics that can be expected from such a ETF/stocks stat arb strategy? Like % win, avg win/avg loss ratio, Sharpe ratio, trade frequency, etc. I saw some job posting looking for stat arb traders with Sharpe ratio between 5~15. That seems insanely high to me(maybe not so high for the pros on ET). Is that really achievable?

For the ETF/stocks arb, do you feel any performance degradation over time? Since most of the liquid ETFs are supposed to be "efficient" due to all the arb from large funds/institutions, it's hard to imagine there would be any edge left to be exploited by retail traders.

 

Hi again

Aug 2007 – intra-day strategies were profitable virtually every day – certainly net profitable at 31 Aug. For the whole month – arb strategies held overnight, minor profit at month end but there was a nasty drawdown mid month.

Returns – for your standard ETF versus basket your return will be about 2-5% per trade (when profitable!). At Chan’s website he has a fully disclosed ETF versus basket strategy using XLE and his real world example gets 3%. Stat arb is for grinding out regular profits; you don’t get massive wins, or massive losses – though you can get a fright like Aug 2007. That’s why you need to see all your trades in the context of a holistic risk management strategy. What is your capital allocation per pair, can you hedge the whole portfolio, what’s the correlations between those trades etc. It’s at these points you can add a real value to your complete strategy.

Sharpes – I won’t enter a trade unless it has a back tested theoretical Sharpe of at least 2.5, but actual realised Sharpe tends to be 1.7 – 2.1. The real world is never as good as your back tests! But having said that I have stuck with some pairs that were in the low 1s.

I see an ad in efinancialcareers.com today where they say - Minimum Sharpe ratio of 4, Sharpe 10-15+ preferred.

I have never met anyone with a consistent Sharpe of over 4.5 but I am confident they exist. However, 10+ seems impossible for a price taking retail trader paying the spread. Maybe a market maker can substantially reduce their standard deviation of return and therefore they have a higher implied Sharpe. I understand theoretically how you could do it in a high frequency low latency situation and I know some good algo boys but they are nowhere near 10+. I also see that the ad says equities, so I’m as keen as you to know how they do it.

Performance degradation: Statistical relationships break down. Management can stuff a company up, FDA approval can be delayed, investors lose interest in companies and suddenly things don’t track the way they used to. That’s why over night I am running combinations of virtually every stock, ETF and option against basket regressions and then keeping a track of their theoretical past performance.

I guess my approach is more dynamic stat arb, you may need to make basket changes more regularly than you think.

Average holding period is about 17 days for the over-night basket trades.

Why hasn’t all the edge been sucked out by the hedge funds? Because I am not entering or unwinding million dollar positions, I (and you) can be more nimble due to our size of transaction so we can get a good entry/exit price; we don’t have to scale in over say a 5 cent range.

Secondly I can trade what I like, I don’t need to run my ideas past a manager.

Also I have got hedging on some baskets plus I’ve got pairs running across (on the surface) stocks that seem to have nothing in common (hint: look deeper – maybe same supplier, maybe the stock price has a high regression to a particular economic factor, there’s always an reason).

Stat arb isn’t very sexy. You don’t needs screen full of indicators, in fact most of the work is actually pretty boring. The computers just grind over data for hours on end punching out averages, correlations and probabilities. Even when the trades are placed you don’t have to watch your trades tick by tick. However, it’s this procedural approach - a bit like being in a job, combined with the (in my case) regular grinding out of profits that I find appealing. It insulates me from the massive emotional highs, lows and frustrations that I used to experience as an options trader.

Stat arb isn’t for everyone but Ezbentley – your time spent investigating stat arb will be well worth it. Enjoy the journey.

 

Hi Matt,

Thanks for sharing your experience with someone totally ignorant of stat arb. It does seem like an interesting strategy that I shall study at least a bit in the future.

Best Regards,

 

Hi Matt,
I am wondering if you can share anything about your experience with intraday stat-arb. A lot of people claim that the mean reversion required for the typical stat-arb takes longer to unfold, so I am curious about what you've experienced with your intraday positions, and how it compares to the longer-term ones.
Thanks.

EJ.

 

Matt, one more question for you.
There has been a lot of talk about stat-arb funds underperforming during the rally that started in early march. I am wondering if you have seen anything out of the ordinary in your trading?

(http://www.businessinsider.com/how-the-quiet-quant-bloodbath-might-tank-the-market-2009-4

http://www.ft.com/cms/s/0/ae73a390-29e6-11de-9e56-00144feabdc0.html?nclick_check=1

http://www.rgemonitor.com/financemarkets-monitor/256414/merrill_let_loose_on_the_quant_scent
)

 

Nice to hear a refreshing voice here.
Where did you hear Gummy's site is going down? I added to some of the topic ideas in the past. You folks better jump on it before it's gone. Good things don't often come for free.